Don’t Put Us Back in the Gold Cage

The Federal Reserve’s third round of quantitative easing announced in September has deepened fiscal conservative fears of runaway inflation. These conservatives are instead advocating a return to “sound money” policy in which the dollar is tied to an external standard, instead of the freely floating currency that the United States currently has. The Republican Party platform calls for an audit of the Federal Reserve and proposes a “gold commission” to study restoring the link between the dollar and gold (Harding et al 2012). Inflation, however, has remained under control and even below target levels. Returning to the gold standard or another form of sound money policy is a bad idea that would certainly lead to a worse economy.

Monetary policy and fiscal policy are tools that a government and central bank can use to fight economic downturns. When demand in the private sector drops, they can step in with fiscal and monetary stimulus. The United States government and the Federal Reserve have used these tools to counteract the recent economic crisis through a fiscal stimulus package, near zero interest rates, quantitative easing, and other unconventional forms of monetary policy. Many proponents of these measures argue that they were too small to promote a full recovery but nevertheless saved the economy from total collapse.

Though economic stimulus may have prevented another Great Depression, the economy remains depressed and unemployment remains high. So many conclude that if the stimulus did not get the economy back to normal, spending cuts and a stable money supply must be the answer (Eichengreen 2011). At the extreme, some high-profile conservatives, such as Lewis Lehrman and Steve Forbes, argue for a return to the classical gold standard where a dollar is defined to a fixed amount of gold (Lipsky 2012).

Not every conservative agrees on returning to a true gold standard, but Republicans do agree on the need for what they call sound money policy. The Republican vice-presidential nominee Paul Ryan argues, that such a policy “would end uncertainty, help keep interest rates down, and increase the confidence entrepreneurs and investors need to take the risks required for future growth.” But he advocates setting monetary policy to a market-based price guide, such as a bundle of commodities rather than just gold (Ryan 2009). This is similar to the gold standard, but instead of the currency fluctuating with the price of gold, it is tied to the prices of the needs of the economy, such as oil, corn, and cotton (Klein 2012). Though rejecting the idea, Paul Krugman explains the reasoning for a sound money policy. “Why not ensure monetary virtue by trusting not in the wisdom of men but in an objective standard?” (Krugman 1996).

However, sound money policy does the opposite of what monetary policy should be doing. Interest rates rise in downturns and fall during good times, but a central bank should be lowering interest rates in downturns to fight off recessions and raising them in good times to prevent inflation and keep growth at a sustainable pace (Delong 2012). With Ryan’s plan, a drought that causes food prices to rise or a conflict in the Middle East that affects oil prices would cause interest rates to rise and could lead to a recession (Klein 2012). Furthermore, the Fed would not be able to act as the lender of last resort to the financial system unless it could come up with more gold, or under Ryan’s plan, could increase the supply of commodities. As Barry Eichengreen argues, “Given the fragility of banks and financial markets, this would seem a recipe for disaster.” People in favor of the gold standard think that it would assure financial stability, but that is not the case. When the United States was on the gold standard, there were many more financial crises and sovereign debt defaults than today (Eichengreen 2011).

Moreover, sound money policy risks repeating the mistakes of the 1930s. The gold standard deepened the Great Depression in Europe and the United States by causing deflation. Abandoning the gold standard opened the door to recovery by allowing countries to depreciate their currencies (Eichengreen 2012). This currency depreciation increased output and reduced unemployment in the devaluing countries by increasing the price of imports and allowing for an increase in exports. This made domestic goods more attractive and encouraged domestic investment (Eichengreen et al 1985). Today, we are seeing the same situation in Europe. Countries such as Greece, Italy, and Spain, which are on the euro and therefore do not control their own monetary policy, have shown the downside of fixed exchange rates and inflexible monetary policy (Krugman 2012b). In contrast, flexible exchange rates and currency depreciation have been vital to countries, such as Poland, Sweden, and Iceland, that have handled the crisis comparatively well (Krugman 2012c).

In conclusion, returning to the gold standard or another sound money policy is a bad idea that would surely worsen our already weak economy. The soaring budget deficits and increased money supply are a result of the global economic crisis, not the cause. We need to learn from history, and not repeat the same mistakes. As John Maynard Keynes said after Great Britain abandoned the gold standard, “They must not allow anyone to put them back in the gold cage, where they have been pining their hearts out all these years” (Krugman 2011).